Abstract
Fitoussi and Phelps (1986; 1988) addressed the international transmission of fiscal shocks through the world real interest rate, but without explicit treatment of agents’ optimal decisions. Various other authors have examined the international aspects of fiscal policies and productivity shocks in models where agents’ intertemporal objectives and constraints are explicitly modelled.1 In those models, the world rate of interest also plays an important role in channelling the impact of various economic shocks but they all postulate full employment throughout. In this chapter, we adopt a modelling strategy where agents’ intertemporal decision problems are solved explicitly but where we use a dynamic version of the classic Salop (1979) natural rate model in describing each economy.2 We show how world interest rates adjust in response to exogenous shocks and how they affect the evolution of the equilibrium rate of unemployment.
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